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How to Figure if a Roth IRA Is Your Best Option

By

Kelly Greene

Updated Jan. 12, 2008 12:01 a.m. ET

Everyone I know is telling me that a Roth IRA is a better deal than a traditional IRA, but I'm having second thoughts.

My wife and I are in the 28% tax bracket. It may sound nice that all gains from the Roth IRA are tax-exempt, but is the 28% front-load tax worth it? I figure it will cost my wife and I each $5,120 this year to gain the benefit of a $4,000 investment in a Roth IRA, including the taxes.

I'm not sure what tax bracket we'll be in when we start withdrawing money some 35 years from now. But assuming we're in the 20% bracket, wouldn't the traditional IRA be better for us by allowing us to keep an extra $1,120 each that we can invest elsewhere? Assuming we put all of that saved tax liability into an investment account every year, wouldn't it pay for all of the taxes we'd have to pay on withdrawals from a traditional IRA?

—Kam F. Siu, Brooklyn, N.Y.

If you're in a higher tax bracket now than you will be in retirement, you're right to invest in a traditional individual retirement account -- with one big caveat, says
James Linck
,
an associate professor at the University of Georgia's Terry College of Business in Athens, Ga. You would need to take the "extra" money you have due to the immediate deductibility of the traditional IRA and deposit it into some other type of tax-deferred account, such as a 401(k) plan, Prof. Linck says. You could even buy nondividend-paying stocks and simply hold onto them so you owe no taxes until you sell them. "If you can contribute that money [saved in taxes] into anything that's tax-preferred, you're going to be better off with a traditional IRA," he says.

The 2008 IRA contribution limits increased to $5,000 (or $6,000 if you're 50 years old or older), so you can sock away even more than you had planned. Also, you aren't exactly saving $1,120 in up-front taxes by not investing Roth IRA because your tax bracket is the rate you pay on the last dollar you earn at the end of that year.

If you don't invest that extra money in a tax-deferred account, you would come out ahead with a Roth IRA. "You do have to pay the taxes now [to invest in a Roth], but you have $4,000 growing tax-deferred, none of which will ever be taxed," says
Christine Fahlund,
a senior financial planner at T. Rowe Price Group Inc., a Baltimore investment-management company.

Another advantage of investing in a Roth: Once you hit age 59&frac12; and have held the account for five years, you can start withdrawing earnings from a Roth with no penalties and no taxes. And you are never required to make distributions, as you are with a traditional IRA every year starting in your 70s. Your heirs would have to make annual distributions from an inherited Roth account -- but they wouldn't owe any taxes on them.

The looming question is whether your tax rate will be lower than what you pay currently by the time you retire. Some experts contend that tax rates are comparatively low at the moment. "Historically, 28% isn't all that bad," Ms. Fahlund says. "There were years when people in the highest bracket paid 50%, or even 70%."

Still, "most people don't make as much income in retirement as they do when they were working," Prof. Linck says. "Also, investment income is taxed differently than earned income. My view is that I have a tax problem today. I know that for sure. If I have a huge tax problem in retirement, I hope it means that I saved enough to retire and live on."

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